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Using a HELOC as an Alternative to Refinancing

Recently I was talking with a buddy of mine, who happens to be a higher-echelon employee for a major bank, about my desire to refinance into a longer-term home loan in order to provide me with additional financial flexibility in the event I ever lost my job.

Eventually, our conversation migrated over to when people want to remortgage with bad credit and then on to the case of my mother-in-law. I wanted to also refinance her mortgage for maximum flexibility because she has a very limited monthly income that will become even more limited when she finally retires. Unfortunately, although she is 65, she has very little saved for retirement and therefore she will be almost entirely dependent on her social security payments in the coming years. Here is an approximation of her current situation:

Monthly Social Security Income: $1000

Monthly Mortgage Payment: $400

Remaining Mortgage Balance: $40,000

Value of House: $200,000

As you can see, once she retires her mortgage will eat up roughly 40% of her social security payments, making life quite difficult for her.

After hearing these details, my banker buddy offered up what I think is an ingenious and brilliant alternative to refinancing that was just too good to believe. I’ll paraphrase his words to me: Why don’t you have your mother-in-law take out a home equity line of credit (HELOC) for the amount of the mortgage and then pay off the mortgage? If minimizing her payment is the ultimate goal, she can pay only the monthly interest payment on the HELOC.

What! Why would anybody ever do that? Isn’t it true that the interest rate on the conventional fixed rate home loan is lower than a HELOC?

It is true that the HELOC carries a higher interest rate than if she refinanced into a conventional fixed-rate home loan. But the beauty of this plan is that unlike the mortgage on a conventional fixed-rate loan, the HELOC would permit my mother-in-law to pay only the interest due each month. At current rates, this strategy would lower her monthly payment to somewhere in the vicinity of just over $100 per month. (As an aside: many folks may be interested to know that it is possible to get a HELOC, or even remortgage with bad credit.)

But if you only pay down the interest every month you’ll never pay off the house! I know what many of you are thinking: Okay, Len, what is going on here? Just the other day you were spouting off that for those who want to reduce risk by agreeing to trade the desire of making more money over the short run in exchange for the security and promise of a steady risk-free return, paying-off the mortgage was a no-brainer!

And in most cases, that is still true. But there are ALWAYS exceptions to the rule. In my mother-in-law’s case, being a senior citizen with no nest egg to speak of and very limited income, minimizing her monthly payments easily trumps paying off the mortgage. For many senior citizens with limited incomes who are still responsible for paying a mortgage for a home, it becomes logical to ask: what do they have to gain by paying it off, other than providing their heirs with a bigger inheritance?

With all that in mind, for my mother-in-law it basically becomes a trade between these two options:

1) continue to work as long as she can continuing to pay down (for her) an expensive mortgage in exchange for owning the house free-and-clear by her 77th birthday, or…

2) pay off the existing mortgage with a HELOC and then make payments of just over $100 over the next ten years, using the resulting savings to build a small nest egg and give her more a little extra money in her pocket to boot.

Of course, the key to implementing this strategy requires sufficient available equity exists to tap a HELOC in the first place. Fortunately, even after the collapse of the housing bubble, my mother-in-law still has plenty of equity to qualify.

So why not go with a reverse mortgage? Well, everybody’s situation is different. But in my mother-in-law’s case, the HELOC allows her to avoid the steep fees and other loan costs (usually over $10,000) normally associated with reverse mortgages. In fact, many lenders offer zero or near-zero closing cost HELOCs. The high closing costs associated with reverse mortgages are attributed in part to FHA insurance required to cover the risk of the loan balance growing in larger than the home’s equity over time. For my mother-in-law, the savings that the HELOC provides are just too big to ignore.

True, unlike a HELOC, a reverse mortgage wouldn’t have to be paid off until my mother-in-law moves out or dies. But HELOC loan terms can run for as long as 10 years. When that term is eventually reached, she can decide to either sell the house, repay the relatively small balance or refinance.

In the mean time my mother-in-law, by using a HELOC to pay off her existing mortgage, can enjoy a little more financial freedom and hopefully some added peace of mind in her autumn years.

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Comments

It’s a good idea, but with a big caveat. HELOC rates are usually tied to the prime rate, which is about as low as it is ever going to get. My HELOC is currently at 3.5%. Unfortunately, the prime rate can fluctuate a lot. True, even if prime gets to 10%, the monthly interest payment is not going to get to $400, but it’s important that your MIL not base her budget on the $100 payment since it has nowhere to go but up.

I considered the possibility of interest rates getting to a point that would make life uncomfortable for my MIL, and concluded there would be enough options available to us that would allow her to keep her home and reduce her payments. The most drastic being I would simply pay off her HELOC — which isn’t as bad as it sounds since she only owes $40,000 on a house worth $200,000. The interest rates would have to go very high for this to happen.

But she is not a loose cannon with regards to spending; she is disciplined and as a result I am confident she will be okay.

The trick is getting the mother-in-law to agree to the reverse mortgage. I have talked to many seniors about the concept of the reverse mortgage – none of them liked the idea of it – they want their home to go to their heirs, not a bank.

Home equity lines of credit or HELOCs, are a popular source of secured credit for people who require loans in small installments. HELOCs help people borrow against home equity. The equity on the house which is determined by having the home appraised, decides the credit limit of the borrower. The choice regarding how to borrow against this built up equity depends on the kind of financing required by the homeowner.

I loved this article. I recently paid off my home becoming debt free. I then turned around and got a HELOC for 200K. The value of my home is right around 300K. I then bought an RV using 20K savings and 40K from the HELOC. I’m now in full pay off the HELOC mode and the balance is at 35K. Without straying into “you shouldn’t have tapped your HELOC for a nonessential purchase” I wonder if I you think I should focus on building back my E-Fund or continue to pay off the HELOC knowing that I can always tap that as an Emergency fund?

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